Finite Reinsurance

1. Finite Reinsurance Casualty Loss Reserve Seminar Chicago, IL September 9, 2003 Bruce D. Fell, FCAS, MAAA, CFA

2. Disclaimer • The views expressed in this presentation are those of the individual presenters and in no way represent the opinions of the CAS, the Joint Committee of the CLRS, or the presenters’ respective employers. • The presenters take full responsibility for all irrational, incoherent and foolish comments.

3. Agenda • Current Market Environment • Overview of Finite Structures • Overview of SFAS No. 113 and Statutory Issue Paper No. 75

4. Current Market Environment • Interest Rate Environment • Underwriting Environment • Heightened Regulatory Environment

5. Interest Rate Environment • Rates have dropped dramatically in last five years • Time value of money changes dynamics of some transactions

6. Underwriting Environment • Focus on underwriting profit after years of soft market and Sept. 11, 2001 • Fewer finite reinsurers • Exits – Centre, Commerical Risk, Gerling, OPL, Scandinavian, Stockton • Refocus – Am Re, Gen Re, St. Paul

7. Underwriting Environment • Focus on correlation and aggregation • Risks previously assumed to be independent now recognized as correlated (lesson learned from Sept. 11, 2001) • Natural catastrophe aggregations • Focus on credit risk • Cedents focus on quality of reinsurers • Reinsurers focus on quality of cedents

8. Underwriting Environment • Constrained Capacity • Reserve charges from 9/11, soft market and latent exposures have depleted capital • Focus limited capital on best profit potential • Increased premium + fewer companies = increased capital leverage • Supply and demand increases cost of capital

9. Heightened Regulatory Environment • Rating agencies – capital levels and underwriting profit • Auditors – increased disclosures and “truth in reporting” • Stock analysts – redemption from “technology bubble” • State regulators – debate over federal versus state regulation

10. Finite Structures • Retroactive Reinsurance • Loss Portfolio Transfer (LPT) • Adverse Loss Development Cover (ALDC) • Prospective Reinsurance • Finite Quota Share • Aggregate Excess of Loss (Stop Loss) • Traditional contracts with “finite” features • Combination of coverage

11. Common Contract Provisions • Experience accounts • Profit commissions • Aggregate limits • Loss ratio corridors • Cancellation provisions • Delays in payments • Adjustable premium, limit or commission

12. LPTs & ALDCs • Reinsurer accepts ceding company’s reserve uncertainty in exchange for a fixed premium • Pricing based on: • Reserve level • Expected payment pattern of reserves • Variability of reserves and payment pattern • Expected interest rate • Reinsurer’s capital costs and risk margin

13. LPTs & ALDCs

14. Loss Portfolio Transfer • Contract provisions • Aggregate limit • Experience account refunds • Commutation provisions • Benefits • “Transfer” existing reserves to reinsurer (reduce reserve leverage) • May protect from adverse development • Establish “fixed” current price for uncertain future reserves

15. Loss Portfolio Transfer Example • Premium = $120 million • Limit = $150 million • Reinsurer’s Margin = 3% ($3.6 million) • Crediting Interest Rate = 2.0% • Experience account refund @ commutation =Premium - Margin - Losses + Interest

16. Adverse Loss Development • Contract provisions • Aggregate limit • Possible experience account refunds • Commutation provisions • Benefits • Protection from adverse development • Establish “fixed” current price for uncertain future reserves

17. Adverse Loss Development Example • Premium = $40 million • Limit = $50 million excess of $100 million • Reinsurer’s margin = 5% ($2.0 million) • Crediting Interest Rate = 2.5% • Experience account refund @ commutation =Premium - Margin - Losses + Interest

18. Finite Quota Share • Reinsurer accepts percentage of cedent’s premiums and losses in exchange for ceding commission • Contract Provisions • Sliding scale commission • Loss ratio corridor • Aggregate limit

19. Finite Quota Share • Pricing based on: • Expected loss ratio • Size of slide, corridor and aggregate limit • Reinsurer’s capital charge • Benefits • Surplus relief from ceding commission • “Transfer” premium to reinsurer (reduce premium leverage)

20. Finite Quota Share Example • Provisional ceding commission = 35% minimum = 25% @ 70% loss ratiomaximum = 40% @ 55% loss ratio • Loss corridor between 70% and 75% loss ratio • Reinsurer’s margin = 5% between 55% loss ratio and 75% loss ratio • Aggregate Limit = 100% loss ratio

21. 50% Finite Quota Share Example

22. Aggregate Excess of Loss • Reinsurer provides corridor of protection over cedent’s expected results in exchange for fixed premium • Contract Provisions • Aggregate limit • Experience account refunds

23. Aggregate Excess of Loss • Pricing based on: • Expected loss ratio results • Variability of loss ratio • Size of experience account refund • Interest rates • Benefits • Aggregate protection of underwriting results

24. Aggregate Excess of Loss Example • 10 loss ratio points in excess of a 65% loss ratio (maximum of $9 million) • Maximum subject premium = $90 million • Reinsurance premium = $6 million • Reinsurer’s Margin = 10% ($600,000) • Crediting Interest Rate = 2.5% • Experience account refund @ commutation =Premium - Margin - Losses + Interest

25. Aggregate Excess of Loss Example

26. Traditional and Combination Coverage • Many “traditional” reinsurance contracts include “finite” features: • Corridors, Aggregate limits, Adjustable commissions, etc. • Some finite contracts include traditional coverage to add risk • Section A = finite quota share • Section B = excess occurrence (cat) coverage

27. GAAP and Statutory Reinsurance Accounting • SFAS No. 113 • Effective 1993 • Statutory Issue Paper No. 75 • Effective 1995 • Both outline determination of whether contract is reinsurance and if so, the appropriate accounting treatment

28. SFAS No. 113 Decision Tree Does contract indemnify cedant against loss/liability? No Use deposit accounting AICPA: SOP 98-7 Yes Is contract short duration or long duration? Long Account for as long duration based on FAS No. 97 Short Is contract Prospective or Retroactive? Account for as Prospective Reinsurance based on FAS No. 113 Account for as Retroactive Reinsurance based on FAS No. 113 Retroactive Prospective

29. Indemnification Against Loss • Reinsurer assumes significant insurance risk under reinsured portions of the underlying insurance contracts • It is reasonably possible that the reinsurer may realize a significant loss from the transaction • Risk must not be remote with regard to timing and amount

30. Evaluation of Risk Transfer • Present value of all cash flows under reasonably possible outcomes (premiums, losses & commissions) • No regard to how cash flows are characterized • Same interest rate for all tested outcomes • Exception: If substantially all insurance risk relating to reinsured portions of underlying contract has been assumed by reinsurer!

31. Prospective versus Retroactive • Prospective – assumption of future events • Retroactive – assumption of past events • Contract having both elements must be accounted for separately or as retroactive • Retroactive also includes: • Claims-made reinsurance of occurrence insurance • Prospective reinsurance not finalized within 9 months of inception

32. Statutory Exceptions to Retroactive Reinsurance • Structured settlements • Novations • Termination of/reduced participation in reinsurance treaties • Inter-company reinsurance arrangements, as long as no “surplus creation”

33. Contact Information Bruce D. Fell, FCAS, MAAA, CFASenior Vice President JLT Re Solutions, Inc.1009 Lenox DriveP.O. Box 6400Lawrenceville, NJ 08648609-896-0555 ext. 402bdf@jltre.com